The Smartest Man in Global Capital Markets on the Fed, China, and What's Next for World Markets

By Joe Digiammo  JUN 27, 2013 1:55 PM

In our latest interview with TSMIGCM, we take a tour around the world and review the impact of QE.


He’s back…

When he speaks, the Fed minutes are revised.

When they're planning Davos, they check his schedule.

Bernanke has him proofread his remarks.

Apple (NASDAQ:AAPL) changed the color of the iPhone because he did not like it.

He is "The Smartest Man in Global Capital Markets." Or, "TSMIGCM." And he is our anonymous guide to the markets ahead. (See also: The Smartest Man in Global Capital Markets on When the Music Will Stop.)

Among the salient events TSMIGCM has predicted for us: 
I am very happy to bring you all Ron’s latest exclusive interview with TSMIGCM, who has been hard at work for us and for you from his humble abode in the municipality of Saanen in the canton of Bern, Switzerland. He's freshly back from whirlwind tours across the globe with finance ministers, the heads of global think-tanks, the CEOs/CFOs of the world’s largest pension funds, corporations, supra nationals, agencies and sovereigns. His views are respected by them all, and his “views” are based on relationships that dwarf the mere North American-European focus of the Bilderberg Meetings. TSMIGCM is an international banker/billionaire, high-net worth client of the firm, and one of the world's most sought-after seers.

Part I – The Fed (as told to Ron Quigley)

Well now, it has been several months since I told all of you what would happen… and it happened!

It's quite amusing to listen to all the bantering on American television; I suspect people there just need to live perpetually in fear of something. They particularly love market carnage. They must have nothing better to do with their time. 

Let us now try and set the record straight, and provide some reason.

The Fed has lived in fear of essentially three things: 1) deflation, 2) a "redux" of 1994, and 3) severe and unrelenting policy "backlash" from abroad as it regards the impacts of quantitative easing (QE).


Deflation, not unemployment, has been at the core of what all the central banks are doing. They fear deflation with good reason: It is immensely difficult to solve for in a short to intermediate timeframe. Witness Japan. The banks are all trying to "reflate." They have been nervous since all the reflationary mechanisms have just about been exhausted, and most reliable gauges of future pricing pressures are not registering a heartbeat. Commodity prices across the board, precious metals, industrial metals -- everything that is supposed to move up has been moving down. The inflation numbers are more important than the employment numbers. As I have said before, "structural unemployment" in the US is arguably at 6% (this versus the 4% to 4.5% level Alan Greenspan quoted more than 15 years ago). 
A “Redux” of 1994

I was writing about 1994 way before the madding crowds. When pressed on this topic, Greenspan and his NY Fed President William McDonough always suggested it was their singularly largest disappointment at the central bank. They were convinced they had winked and nodded enough times to sufficiently "suggest" to markets that a rate hike was coming. But in February 1994, after a 1993 credit cycle that remains the most superior analogy to 2012 through April 2013, upon raising rates, emerging markets spreads gapped 500+ basis points, Mexico imploded under the weight of massive capital flight, and the financial markets seized up.  Let there be no mistake about it -- current Fed Chairman Ben Bernanke, much more an advocate of an efficient, transparent, and consistent FED communications strategy than Greenspan, knew this and knows this. 

Augustin Carstens, Governor of the Bank of Mexico, has been warning the Fed that he has been seeing significant speculative capital flows into his country, which is reminiscent of 1994. Asset bubbles were manifesting themselves everywhere, including in Japanese commercial real estate and J-REITs, Southeast Asian banking centers, emerging markets local currency funds/assets, emerging markets FX rates, MLPs, and REITs in the US.

Six plus weeks ago, Bernanke did nothing wrong in his Congressional testimony. He hesitated one or two times and suggested that QE would, by definition, have some unintended consequences if prolonged in perpetuity. This was enough. We should be thankful he did that. Money supply was going up, however, given the new and confused regulatory environment, and the financial system was unable to act as an efficient transmission mechanism to augment the velocity of money; henceforth, the likely legacy of QE could be the harmful long-term consequences it would have on savers (of all kinds), pension funds, retirees, and insurance companies. Therefore, what Bernanke was in fact doing was intentionally letting some air out of the bubble. 

All of this near term repricing of many asset classes has been overdue and necessary, and it will likely assist in full-year 2014 being a rather constructive one as opposed to another 1994, 20 years later. Severe and Unrelenting Policy Backlash From Abroad Regarding the Impacts of QE

Mexico has not been the only country challenging the US Fed on its policies. From Brazil to China, and from Russia to Germany, this was fast becoming a well-rehearsed chorus of angst. This has happened in an environment that can best be described as a "Buy America" one. Many smart money managers and foreign companies have increasingly been advocating the purchase of US assets of all kinds.  When traveling the world, this can be heard everywhere; it is the trend today.

The idea that the US FED is the cause of everyone's problems has become quite the rallying cry. Take Brazil as an example. They have advocated capital controls more times than I can count to protect their currency from rallying against the dollar and infringing on exports.  But the Fed has barely made a left turn in the road, and the Brazilian reais has collapsed to an exchange rate of 2.27 reais per US dollar. The problem with Brazil is that it is an emerging market, and not an emerging superpower. It has a poor and marginally competent government; labor costs have skyrocketed, as have commercial real estate prices -- that is, when it can be found in the Faria Lima district of Sao Paolo, it is way too expensive; labor unions have vast power; the state immerses itself in every aspect of production; and the country is vastly overregulated. I have met dozens of emerging market debt and equity investors and IB clients during these past weeks, and for the most part, they were negative on Brazil. A country that should by all accounts be growing at a 6-7% annualized GDP is growing below 1%. So, the Fed will migrate away from QE; the US dollar will strengthen. Then who will the Brazilians blame? As can be seen by recent social unrest, they have finally gotten it right -- themselves!!
Summation of Part I

To sum all this up, I recently had a lunch with a hedge fund manager I have great respect for. You would all know the name, but I can't reveal it. I outlined my view that the "liquidity unwind" would create 1994-like distortions in credit and fixed income markets. Upon finishing, I was told that my guest was in complete agreement with me but for one thing. What I was missing, so he said, was that there would be "no exit strategy." The Fed, he suggested, viewed QE as binary; it would go on for a very long time precisely out of fear of another 1994 at a time when EMEA banks were still weak, Japan was dancing on the periphery of irrelevance, China was slowing down, and most importantly, the central banks had no more arrows left in their respective quivers. “Forever,” I was told. 

Give Bernanke and the Fed credit; they see and know all of this. They very meticulously -- almost forensically -- orchestrated a "correction" that amounted to 5% in equities, 5-10% in select US Credit Products, and 15%+ in emerging markets-related asset classes and currencies. This was necessary! Central bankers have maintained for years that they should not manipulate and manage asset prices.  Today, that is exactly what they are doing. There has been no coherent US fiscal policy to assist the Fed in its quest to salvage US growth and reflate. History will prove this true.

Part II - GEOGRAPHIES (Select Thoughts on Countries of Interest)


QE will fail in Japan. Unlike the US, which has awesomely flexible labor markets, lots of transparency, reasonable immigration policies, and few subsidy-related distortions in its economy, Japan is subject to many rigidities that do not set the preconditions for QE to succeed. Virtually no one of consequence in Washington, DC, thinks that the Japanese will succeed. But as I have said before, there are a couple positive signs.
The country recognizes that the current demographic trend does create a sense of urgency regarding the exporting of business models to other jurisdictions and increasing foreign direct investments (FDI) across the globe, preferably where demographic trends best offset what's happening at home. As an example, Japanese multi-national companies have been very reticent to increase FDI in India for many years. India is an integral part of the US-China containment strategy, and it has been an imperative of US policy wonks to encourage Japanese FDI in that country.  Having recently spent a full week there, it is clear that this is now happening. Japanese policy banks -- like the Japan Bank for International Cooperation and the Development Bank of Japan -- are providing almost $8 billion in guaranteed loans to help construct the Mumbai-Delhi Corridor Project, all in an effort to illicit more FDI. Japanese Prime Minister Shinzo Abe has targeted another $45 billion in Japanese FDI for India in this year alone.

So corporate Japan is on the move, as it should be. The real bottleneck to QE will be the consumer and the country's inertia in terms of agricultural reform, immigration policy changes, and other issues. These things will hold Japan back. The likely result will be an over-reliance on the things they are comfortable with; thus, there will arguably be much more FDI in global emerging markets. The target list for this investment includes Vietnam, Thailand, Indonesia, The Philippines, Myanmar, India, Brazil, Mexico, Poland/The Czech Republic, Germany, and the US. China

As I have written before, the real issues in China are excessive credit, volatility in policy prescriptions to deal with market dislocations, and the margin of safety between the equilibrium level of GDP growth (ELG) and the "actual" GDP growth rate.  As my good friend Seth Klarmen wrote years ago, "Margin of safety in value investing is the 'key.'" This rule should also apply when analyzing sovereign credits. It is not possible to know the exact annualized GDP growth rate below which China would be unable to absorb all the new workers coming into the system each year; it is equally difficult to ascertain what China's actual GDP growth rate is in real time. What we do know is that the margin of safety (the delta between the two) is too narrow for comfort.  I assume the ELG is currently 6.5% (down from 8.0% more than five years ago, primarily due to China's changing demographics) and the actual GDP rate is approximately 7.0% (not the 7.7% the PRC suggests). Thus, the margin of error here is very narrow. 

It is precisely this narrowing delta that pushed policy makers to make abrupt modifications to policies and regulations. China is very fixated on being perceived as an adult on the global stage. Having to choreograph a massive spike in Shibor to "punish" speculators is inconsistent with the image they want to cultivate. As the Japanese migrate new FDI away from China to Myanmar, India, Indonesia, Thailand, Vietnam, and The Philippines, and as China slowly loses its labor cost advantages versus other key emerging markets manufacturing economies, the risks of a real China slowdown will grow over time. The impact on Latin America will be severe, most notably on Brazil where we are already seeing signs of social unrest.

I do not see China slipping below its ELG this year, but if and when this does occur, it will unleash more deflationary forces around the globe. In my last article, I argued that the Shanghai Composite (SHA:000001) would have to breach the 2,000 level, and this has now happened. It may, in fact, have to go lower in order to persuade the authorities to increase the liquidity taps once again. China is, at the end of the day, a bit of a shell game economy.  The government meticulously arranges share sales between institutions (corporates, banks, etc.). I do not see this ending well.  We may not get the conflagration prophesied by Jim Chanos, but it is likely to be close. It won't happen this year, though.



One of the benefits of massive market dislocations is that they tend to enhance transparency in terms of the true or intrinsic value of credits, asset classes, and countries. This is true of Brazil, where we are now seeing social unrest.

Brazil's President Dilma Rousseff's solution is to increase spending and social outlays; this will only be a very near-term solution, if that.  The currency will remain under pressure; it may trade as low as 2.5 reais to the dollar. Some well-situated hedge fund managers have actually asked me recently to what extent I felt Brazil would have a real crisis -- for example, a run on a bank.  I do not see that happening, however, current events are constructive in that they point the finger at over-regulation, excessive government at every level, and antiquated labor laws. Now that the US Fed is no longer the "bad guy," we can get sufficient introspection there that leads to substantive change. I have been very negative on Brazil versus Andean/Mexico for several years. Now, however, it would appear to me that Brazilian equities -- for the first time in several years -- are fairly priced relative to those alternative markets. Some very smart and agile equity managers are increasing Brazilian exposure purely on that basis. 

Consequently, I do see Chile, Colombia, and Peru as having gotten somewhat expensive. This will not deter the Canadian pension funds from continuing to prioritize infrastructure assets in those geographies, but it will make it more difficult to monetize the equity of locally domiciled businesses, in my view. 

Carstens has gotten his way in so far as the Fed has at least suggested that QE will not be a permanent policy. Hence, some speculative capital flows have departed Mexico, relieving pressures on the peso/dollar cross currency rate near term. To the extent that the PRI government can keep the cartels at bay and continue its commitment to deregulating the inertia inherent in the Mexican economy, I still like the investment thesis there and still see tangible evidence of increasing FDI flows that could add 1-2% to Mexican GDP estimates going forward.  Argentina

I spent some time in Argentina recently as well. The government is, as you all know, not competent and failing its people; this is a very widely held view. Many producing assets are trading at levels below replacement value. To the extent that we see a shift away from President Cristina Kirchner in the upcoming October elections, I am of the view that asset prices can improve. Well-placed private equity professionals across Latin America are circling some producing assets in that country. They view it as one of the very few opportunities to increase an initial investment fourfold or fivefold in several years, assuming the electorate wakes up. This merits watching for anyone fixated on alpha generation, notwithstanding the current emerging markets fallout we are witnessing across the globe.

No positions in stocks mentioned.